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Conflicts Of Interest In Investment Banking: What Is The “Right” Answer?

Posted on Saturday, May 29th 2010

By guest author Jim Heinzman

[A few weeks ago, I wrote a Forbes column titled Financial Reform: Legal Vs. Right in which I discussed the interrogation of Goldman Sachs executives by members of Congress following the SEC's lawsuit against the firm and argued that even if not guilty in a legal sense, Goldman and its CEO Lloyd Blankfein must admit to wrongdoing, and Blankfein and his peers should follow the example of George Soros and explain what they think meaningful reform of financial market regulation would entail. Further, investment bank executives should work with the government to institute such reform. Reader Jim Heinzman, Managing Director of Securities Solutions at Actimize, wrote the following essay in response to my column.]

When it comes to the conflicts of interest in terms of investment banking, the finger-pointing continues. Many people, including those on both sides of the aisle [in Congress], think that government pressure to make home loans to people who really could not afford them was a major contributing factor to the recent turmoil in the investment banking space, others attribute it to lax and inept regulation, and still others blame it all on greedy Wall Street “fat cats.

So who’s at fault in this mess? And who is going to clean it up? Government? Regulators? The financial services industry? Will change require a parochial approach or a global initiative? They will need to find a more effective way to work together if we are to see meaningful change. Most of us are tired of getting political answers to important questions rather than getting to the “right” answer that actually solves the problem it was intended to address. The way out of this will be a combination of strong bipartisan leadership, effective regulation, higher industry standards and, perhaps, global coordination across all fronts.

One argument I hear a lot is, “If other service providers like lawyers or CPAs have rules and standards to effectively avoid conflicts between the interests of their clients and the firm, why can’t that be done in the financial industry?” Multifarious organizations have a long history of grappling with the conflicts that are inherent to their business models. They will be judged, under the new paradigm, by their successes in identifying and resolving those conflicts. The current financial debacle has spurred many proposals that will have very profound consequences on the financial industry.

We should carefully consider the impact of such proposals. It sounds good to politicians: protect clients and create fiduciary obligations for broker-dealer firms to their clients (Blankfein correctly pointed out that he does not currently have such an obligation); provide regulators, and the regulated, with bright-line tests that could be applied; eliminate proprietary trading (however that’s defined) in the spirit of the “safety and soundness” principles. The government is now afraid of having institutions that are “too big to fail.” Today, large global investment banks provide a broad range of financial intermediary services and have such a large and diverse client base, that conflicts between the interests of an investment bank’s clients, the bank itself and between multiple clients of the bank are not uncommon. If too strict requirements were put into place, it could force today’s mega firms to divest conflicting businesses and clients. The result would be many boutique firms specializing in a few products and services and catering to the needs of a narrower band of clientele. Would the industry, the clients they serve, and the economy benefit more from a dismantling of a business model that has, arguably, worked reasonably well in the past? Perhaps the answer lies in a concerted effort to effectively manage the inherent conflicts in that business model.

We should exercise caution before returning to the model that dominated the United States landscape before the repeal of provisions of the Glass–Steagall Act, specifically those previsions that prohibit a bank holding company from owning other financial companies. The Gramm–Leach–Bliley Act, signed into law in 1999, enabled U.S. investment banks to grow and compete more effectively in the global market place. Reversing this now could negatively impact U.S. institutions from competing. It could have the effect of creating opportunities for foreign banks to capture market share (not to mention jobs). It could reduce efficiencies and drive up the cost of raising capital that drives economic expansion.

But the question remains: Are current regulatory standards high enough, and are investment banks operating with “the highest standards of commercial honor and the just and equitable principals of trade?” Banks that decide to hold themselves to a higher ethical standard may find themselves at a competitive disadvantage to their peers who may not take the same conservative stance. Even with these competitive risks, however, most banks have recognized a need for improvement, and are already pushing toward a more conservative, or some may say “ethical,” approach to conflicts of interest.

The good news is that most large global investment banks do leverage technology to identify and proactively address potential conflicts of interest across the enterprise and within specific businesses. Many of the firms we work with are using our technology to deploy rules and processes to identify and address potential conflicts. Once potential conflicts are identified, there are many ways to address them such as making disclosures, creating information barriers (Chinese walls), passing up on business opportunities, or bringing in independent third parties to advise. Despite popular political bloviating to the contrary, most investment banks are managed by highly ethical and conscientious people who genuinely strive to do the “right” thing. They look for the lines and try to stay within them. It does seem to be poor form for the politicians who set the lines to now attack investment banks because, in hindsight, they put them in the wrong place.

Before things get too far out of hand, there should be a more productive dialogue between the politicians, regulators, and the financial services industry. It is in all of their best interests, yours and mine as well, for them to get together and solve the problem. Does that mean real bipartisan leadership from Washington, better funding for regulatory agencies, and creating incentives for industry participants to adopt higher standards? This would not be a bad start! It is possible that even Mr. Soros may be able to make some positive contribution to the “right answer.” Industry groups such as the Securities Industry and Financial Markets Association (SIFMA) have been trying to bring the parties together and propose meaningful answers, but their success has been hampered by those who seek to put political posturing ahead of finding the “right” answer.

Bottom line: It is time to stop the blame game, and focus on the most important step – the solution – it must become our next great focus if we are to expect to ever get to the “right “answer and create meaningful change that will balance the needs of the marketplace with the risks of financial calamity.

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